Understanding cashflow part 2: How loss-making companies grow.

This is part 2 of an article on cashflow. Click here to read part 1.

I had this explained to me using the example of a supermarket. Let’s say you open a supermarket and stock it with £1m worth of goods (I have no idea of the value of goods there are in a supermarket!). You are paying your suppliers on 60 day terms, you sell through the £1m stock in on average 30 days at an average 25% markup. 

By the end of 30 days you have £1.25m cash in and zero cash out (for goods, you obviously have to pay rent, rates, salaries etc).

At the end of 60 days you have £2.5m cash in, and you’ve only paid £1m for the stock.

At the end of 90 days you have £3.25m cash in, and you’ve only paid for £2m for the stock. 

What this means is that you have a cash surplus, and what do you do with that cash surplus? You open another store. This store operates exactly the same way, so you build another cash surplus and open another store. And another. And Another. This keeps working as long as the stores keep selling.

That’s the traditional way of looking at it, but that model can only grow so fast, as it takes time to find stores, kit them out, staff them etc. Take the same thinking and apply it online. You then see why Amazon has 90 day (yes 90 day!!) payment terms, no stores and why it is the biggest company in the world. 

Amazon has weekly ordering and there are more than 12 weeks in 90 days. This means that Amazon is selling your product (and everyone else’s) 12 times over before they are paying for it. They are doing this profitably, as most companies are paying at least 20% in terms back to Amazon, and then they are charging you to advertise on their site. Remember you are paying for the advertising at least 90 days in advance of getting the income from the product. Many other companies work on a similar model, although Amazon does it best. 

This model allows the companies to build piles and piles of cash. They can then deploy this cash to help them grow, to become more efficient, to scale operations, to build robots etc. Even if the investment in growth makes them technically loss-making, they have the cash to cover the losses (suppliers are effectively lending them money to grow the business) and the basics of the operation are fundamentally profitable. 

As much as we’d like to, we can’t all set up Amazon, but we can learn from it.

Back to the drinks company that grew from £100k/ month to £300k per month but ran out of cash. Let’s assume that the company switched to a DTC model successfully and kept the same growth.

On reading this article, the company managed to negotiate 60 day payment terms with their supplier instead of 30 days. They still hold 30 days worth of stock and they are getting paid on day 1 from DTC customers. 

At £100k per month they have £50k stock, £100k creditors (what they owe their manufacturers) and £0 debtors (the money goes straight into the bank from DTC sales).

If they grow to £300k per month, they have £150k of stock, £300k of creditors (as this is money that they owe, that is the equivalent of an additional £200k of cash in the bank, or a £200k loan from their supplier) and they are banking £300k of cash each month instead of letting the debtors build up. They can then use this cash to hire more people and invest in marketing to further drive growth, because the main lesson to learn here is that you can spend cash, but you can’t spend debtors, even though they have the same ‘value’ as assets on your balance sheet.

It’s worth noting that even though this looks great on paper, a full move to DTC is probably not the right move for the drinks company. The total addressable market (TAM) for people who want drinks home-delivered Vs buying them in a store when they are thirsty is probably a lot smaller. However by bringing in a DTC operation they will bring the average debtor days down, meaning that the DTC helps cashflow the retail sales and they both help each other grow.

So there you have it. As promised, it’s not the most exciting subject in the world, but it is a subject I think people don’t understand early enough and one that was a huge light-bulb moment for me. 

It’s worth adding a note at the end that I am not an accountant, very far from it, I come from a marketing background. There may be better accounts-minded people out there who will find holes in the above. If there is something that needs correcting please let me know. Even if there are mistakes in the figures, there are no mistakes in the concept and it’s the concept that you need to understand, especially if like me this is far outside the area of the business that you know best.